Interesting Conflicts How State Laws Combat Boards' Conflicts of Interest

Interesting Conflicts

There is a natural inclination in business to work with those whom you know and trust. Relying on relationships that have developed over time is just a commonsense way to ensure that you’re getting a fair deal from a competent vendor who will perform their job with inducing minimal headaches. All of this is well and good. But when an individual board member stands to profit from hiring a preferred vendor in any way  – and fails to disclose the true nature of the transaction  – then you’re talking about a potential conflict of interest, which is decidedly less kosher.

Individual states have assorted rules and regulations – usually within their respective condo acts – designed to prevent self-dealing and ensure that association business stays on the up-and-up for the benefit of every owner or shareholder, rather than specific individuals. In New York, for example, there is the Business Corporation Law, under which most cooperatives in the state were created. It’s worth taking another look at the law, similar legislation in other states, and conflict of interest in general. 

In response to the BCL changes, Richard Klein and Emil Samman, partners at New York City law firm Romer Debbas LLP, sent out a packet to their board members advising them as to how the law will continue to affect their associations going forth. For a primer, a portion of that memo is excerpted below:

For years, section 713(a) of the BCL has provided that if a director of a board has a substantial financial interest in a contract or transaction between a contractor or vendor and the board, this interest must be disclosed to the board. In such a situation, that director cannot vote on that contract or transaction and must recuse him/herself from any deliberations on the matter.

Further, Section 713(b) provides that if the contract or transaction was entered into without such a disclosure from the interested board member, the board may void the contract or transaction unless it can be established that the contract was fair and reasonable at the time it was authorized by the board.

Now, effective as of January 1, 2018, the new addition to the BCL has imposed two new requirements on cooperative and condominium boards of directors/managers when dealing with contracts or transactions that would fall into the category mentioned above. 

First, Section 727 establishes a requirement that cooperatives and condominiums must give each board member a copy of BCL Section 713 at least once a year. What is interesting is that as the law is currently written, it would seem to apply to condominiums despite the fact that most condominiums do not typically incorporate under the BCL, or even under the Not-For Profit Corporation Law. So while it is unclear how this new law would apply to condominiums, apparently the New York State legislature is working on a clarification so that the disclosure requirement will clearly apply to condominiums. 

The second requirement is that, at least once a year, an annual report must be sent to all shareholders, signed by each and every director, that lists all contracts or transactions that were voted upon by the board that involved an interested director. This report must include the following information: (i) information on the recipient and the amount and the purpose of the contract; (ii) a record of the meetings of the directors including attendance and how each director voted; and (iii) the date of the vote and the date that contract/transaction became valid.

The board must prepare this report without exception. Even if there were no transactions involving an interested director, then the report must state that “no actions taken by the board were subject to the annual report required pursuant to Section 727 of the Business Corporation Law.

There are still issues to be ironed out here, such as the degree to which someone can be involved with a vendor before it constitutes a conflict of interest, and the specific consequences for self-dealing. But it is clear that the issue is being taken seriously not only in New York but across the country. The spirit of cooperative living depends on transparency and a board abiding its fiduciary duty. Below, we’ll delve further into how conflicts are snuffed out in various markets.

The Windy... State

In Illinois, both the General Not for Profit Corporation Act (IL GNFPCA) and the Condominium Property Act (ICPA) offer guidance pertaining to conflicts of interest, according to Chicago-based attorney Sima Kirsch.

Section 108.60 of the former, for example, “considers a conflict of interest to arise when a director is directly or indirectly a party to a transaction,” says Kirsch, while section 18(a) (16) of the latter “prohibits a board from entering into a contract with a board member or corporation in which the board member or their immediate family has a 25 percent or larger interest, unless two conditions are met: the board must notify unit owners of the intent to enter into the contract within 20 days after the decision is made, and the unit owners must be afforded an opportunity to file a petition and vote to approve or disapprove the contract.”

“Generally, if a director has a ‘personal interest’ in a matter of concern to the association, he or she should recuse themselves – although doing so is a rare occurrence,” Kirsch admits. “Therefore, the board must be vigilant and request the director – even with the protective measures of 18(a) (16) of the Act and 108.60 of the GNFPCA – not to participate in the vote on the issue at hand – which includes deliberation.”

Should that fail, Kirsch suggests that the group alleging a conflict put a petition in writing and send it by certified mail to the board requesting a special meeting to have the board member in question recuse himself or herself. Barring that, the aggrieved are left with mediation – should the association’s declaration have a provision that calls for it – or filing suit. 

“At the core of the conflict of interest issues is the general principle of Illinois law that the ‘duties imposed upon a director of the corporation as a fiduciary requires him to manage the corporation with undivided and unqualified loyalty and prohibit him from profiting personally at corporate expense or permitting his private interests to clash with those of the corporation,’ further that, ‘… a director who has a personal interest in a subject under consideration is disqualified to vote on the matter and may not be counted for the purposes of making a quorum,’” Kirsch explains.

When conflicts of interest arise, the GNFPCA, the ICPA, case law pertaining to the specific topic,  or some combination of the three should provide a remedy. “Many times, it only takes the filing of the lawsuit to resolve the problem, or the first appearance before the court,” notes Kirsch. “Also, owners should be aware that, if they were not advised or did not know of the conflict, than the burden is on the board to offer evidence that the transaction was fair and not detrimental to the association.”

Nor-Eastern

In New England, where co-ops are a rare commodity, the law tends to be less specific.

“Our Condominium Statute (Chapter 183A) does entitle unit owners to make appointments at the locations at which association records are kept, and to view said records, including any contracts with outside vendors,” says Gary M. Daddario, a partner at the law firm of Marcus Errico Emmer Brooks P.C., which has offices in Massachusetts and New Hampshire. “That said, the statute does not prohibit self-dealing. Oddly enough, on that subject, it is not uncommon to see language in an association’s governing documents that specifically allows [emphasis ed.] for self-dealing. In New Hampshire, recent amendments to its Condominium Act (R.S.A. 356-B) at least require certain disclosures to the community in the event that a property manager hired by the association has an interest in a contract that the association enters into with a vendor.

“Self-dealing typically occurs when a board member happens to own or be employed by a company that offers a service or product needed by the association,” Daddario continues. “The instinctive thought process is that the familiarity will result in the association getting the best deal. But the reality is that whether they get the best price or not, the association could end up in a difficult situation. If the project doesn’t go well, or the work isn’t done properly, it will be much more difficult and awkward to address than with a vendor who is at arm’s length. Not to mention that some folks are just naturally inclined to believe that there must have been kickbacks, or other sketchy behavior involved.”

When unit owners have to address suspected nefarious activity in-house, they have a few options, according to Daddario. “For starters, they can replace the board next election. If things are more urgent, they can seek removal of one or more board members pursuant to the removal provision in their governing documents. The most serious recourse would be for the unit owners to seek relief in a legal claim against the board, which is problematic as they would be, in certain respects, suing themselves, as members of the organization, and would likely bear the expense in some way.”

How the Garden State Handles It

According to attorney John J. Roman, Jr., at Hubschman & Roman, P.C., in Palisades Park, New Jersey, co-ops are a rarity in the area, with the majority concentrated in the Fort Lee section of Bergen County. As such, the laws governing condominiums should prove more pertinent when considering conflicts of interest.

“There is very little legislation in the state of New Jersey that governs cooperatives; the only thing I can think of offhand is the Cooperative Recording Act for new cooperatives that were formed after the legislation was enacted, which was back in 1987,” says Roman. “And I don’t imagine that many cooperatives were formed after that date.

“Therefore, anything that’s going to control conflicts of interest in co-ops or condos would be within the Not-For-Profit Corporation Act – which I would assume is similar in nature to the New York BCL, and contains some provisions about disclosure for interested directors – or the New Jersey Condo Act,” he continues. “My advice to boards would be to avoid taking interest in referring out any business unless it’s been fully disclosed, at which point you must recuse yourself from voting on any issue wherein you’d have some potential conflict.”

Should a group of owners or shareholders fear that a board member is engaged in self-dealing, there is action it can take before the subsequent election, whenever that may be. “They could ask to have a board member removed for cause, if cause were determined,” notes Roman. “Or they can inform the Department of Community Affairs and have them get involved. That said, I’m not sure how strongly the DCA would react in these situations. They might look at every complaint, but their actually coming out and taking action may be extremely limited. Barring that, owners or shareholders can file suit, complain to management, put other residents on notice as to what’s going on, or advise the board attorney. And hopefully the board attorney isn’t complicit, or they hadn’t failed to ask some pertinent questions.

“As a board attorney myself,” he continues, “everything I get involved in, I always make it a point to ask about any potential conflicts and ask if board members have any interest in prospective vendors,” Roman adds. “For the most part – and I represent 40-some-odd associations – it’s rare that you see anything like this. If somebody recommends an accounting firm where their son works, normally the rest of the board will refuse to hire that firm. But I’m sure it goes on where, say, a management company has a relationship with some vendors...I’d think these conflicts may be even more common with managers than with actual board members.”

Mike Odenthal is a writer for The Chicagoland Cooperator. 

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